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Tax relief shake-up heralds the year of last opportunities

Industry figures have expressed concerns at the complexities introduced to the tax system which take effect next year. Legal & General head of savings technical Colin Batchelor warns that it may the last opportunity for individuals and employers to make big contributions to pension schemes

There had been considerable concern over the complexity introduced to the tax system by new regulations due to take effect from April 6, 2011, which limit higher-rate tax relief on pension contributions. The Chancellor, however, delivered some welcome news in his emergency Budget speech and promised a review.

The Treasury has since issued a paper entitled, Restriction of Pensions Tax Relief: a discussion document on the alternative approach, with particular consideration being given to whether a reduction in the annual allowance to the region of £30,000 to £45,000 might better meet its objectives. Other additional measures under consideration include:

1: The current exemption to the annual allowance in the year in which benefits are crystallised may be abolished, except in the case of death or serious (terminal) ill health. Cases of ill health, early retirement or redundancy which may increase pension benefits may not be exempt.

2: In calculating the annual allowance for a defined-benefit scheme, the paper states that the existing approach of valuing the increase of an individual’s rights by a factor of 10 understates the value and the Treasury is thinking of increasing this valuation factor to between 15 to 20.

3: Reducing the lifetime allowance limit.

4: In calculating the value of defined-benefits for the purposes of testing against the LTA, a factor of 20 is used for pensions about to come into payment, the LTA revaluation factors will be reviewed and potentially increased.

5: Freezing the value of rights covered by primary and enhanced protection.

If these proposals become legislation, the current tax year 2010/2011 may well be the last year in which individuals might wish to make big contributions. It may also be the last year in which employers may wish to either pay big contributions on behalf of individuals, grant significant increases to pensionable pay or use pension schemes to pay enhanced retirement benefits on ill-health or redundancy (subject to anti-forestalling restrictions).

The impact of the proposed changes is likely to be felt mostly by defined-benefit schemes. They may be dealt a double blow of a reduction in annual allowance and an increase in the valuation factor.

Under a DB scheme, the value of the individual rights are calculated at the beginning of the scheme “input period” and then the value of the rights are taken at the end and a multiplier (the valuation factor) is applied to arrive at the pension savings amount (sometimes referred to as the deemed contribution). The example below demonstrates these principles and shows the impact of a pensionable pay increase of £15,000.

’The impact of the proposed changes is likely to be felt mostly by defined-benefit schemes. They may be dealt a double blow of a reduction in annual allowance and an increase in the valuation factor’

Andy has 35 years of pensionable service under his defined-benefit scheme, which has an accrual rate of 60ths. His current pensionable salary is £110,000 but he receives a promotion and his pensionable salary increases to £125,000. Under the current tax system, the increase in value of his rights over one year are:

((36/60 x £125,000) less (35/60 x £110,000)) = £10,833.33 x 10 = £108,333.30
This is under the current annual allowance of £255,000 so there is no annual allowance charge.
Should the reduced annual allowance plus the increase in valuation factor become law, then the same pay increase, assuming an annual allowance of £40,000 and an increased revaluation factor of 20, would give the following annual allowance charge:
((36/60 x £125,000) less (35/60 x £110,000)) = £10,833.33 x 20 = £216,666.60
£216,666.60 less the reduced annual allowance of £40,000 = £176,666.60 x 40 per cent (annual allowance charge) = £70,666.64 to pay for a £15,000 increase to pay.

If employers and individuals are to make the most of this last opportunity, they should first note that the current anti-forestalling measures remain unchanged by the Budget. Those individuals with “relevant income” (which is not just employment income but taxable income) in excess of £130,000 for this tax year and the preceding two tax years would face a penalty if making an increase to their “normal pension savings”. There is no exemption in the year of retirement.

The only last opportunity for DC and DB members with these earnings is:

  • If their regular (at least quarterly) normal pension savings are below £20,000, increase up to this amount or;
  • Where savings are less regular (less than quarterly), the lower of £30,000 or the average contributions over the past three years applies and they could increase up to that amount or;
  • An increase in pensionable earnings within an occupational pension scheme

Last opportunities for really high contributions therefore lie with individuals who have relevant income below £130,000 a year, that is, not caught by anti-forestalling measures but above the new proposed annual allowance (£30,000 minimum). Their personal contribution limit is 100 per cent of their UK relevant earnings.

’If the protection offered by primary and enhanced protection may be frozen, this year may be the last opportunity to crystallise these benefits and escape lifetime allowance charges’

For these individuals, employers can pay up to £255,000. This sum can be even greater if this is the year in which the benefits from the arrangements are taken (crystallised) – the higher limit is an amount equal to the individuals unused lifetime allowance.

There is, however, the additional condition that the contributions must be justifiable “wholly and exclusively for the purposes of trade”. There are last opportunities for the employer therefore for large contributions, increases in pensionable pay, augmentations to redundancy and ill-health pension benefits and improvements to scheme benefits in DB schemes.

Pension input periods could poten-tially be a spanner in the works and work against making the most of these last opportunities. A Pip is the period over which pension savings are measured. That amount is then tested against the annual allowance of the tax year in which the pension input period ends.

Unless the pension input period ends in the tax year April 5, 2011, a large pension contribution made or pensionable salary increase now will be tested against the new proposed low annual allowance of 2011/2012. The discussion paper, however, acknowledges the issue and says “where necessary, specific rules will be designed to apply at transition”.

If the protection offered by primary and enhanced protection may be frozen, this year may be the last opportunity to crystallise these benefits and escape lifetime allowance charges if appropriate.

We don’t know the final shape of the legislation and the discussion document asks for views, which when received may shape the final regulations into a different direction than these original considerations.

For example, the Government says that it welcomes views on how to support employers to make adjustments to help individuals who face one-off large increases in DB schemes.

On the face of it, though, it does seem to be a year for last opportunities. Any individual with the opportunity and desire to pay a contribution should not miss out.

’The impact of the proposed changes is likely to be felt mostly by defined-benefit schemes. They may be dealt a double blow of a reduction in annual allowance and an increase in the valuation factor’

’If the protection offered by primary and enhanced protection may be frozen, this year may be the last opportunity to cryst-allise these benefits and escape lifetime allowance charges’

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